Monopolistic Competition and Oligopoly

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Why do rival firms sometimes agree to cooperate and other times insist on competing? Why do decision makers in businesses behave as they do? Game theory -- the study of strategic moves and countermoves among rival firms -- attempts to offer answers. To learn more about game theory, visit the International Journal of Game Theory, a quarterly journal founded in 1971 by Oskar Morgenstern. Or visit Al Roth's Game Theory amd Experimental Economics Page, maintained by Al Roth, professor at the University of Pittsburgh.

Case Study Interactive Examples

Case: Fast Forward
While smaller video rental stores were forced to close in the wake of increased availability of substitute goods such as cable television, Blockbuster Video has been able to increase its market share. Visit Blockbuster Video.

Case: The Unfriendly Skies
Strong frequent flier programs help major airlines maintain a dominate position in the market and hinder smaller airlines from expanding their market share. To explore frequent flier programs offered by three major airlines, visit American Airlines, Delta Air Lines, and United Airlines.

"Using the Internet" Problems

Visit Paul Walker's "Chronology of Game Theory," maintained by the Department of Economics, University of Canterbury, New Zealand. How old are the roots of game theory? What is the most recent development?

Study Guide Tutorial

Monopolistic Competition and College

U.S. colleges and universities can be seen as "firms" in a monopolistically competitive industry. Each produces a similar product (education), but the products are not identical. A college can raise price (tuition) without losing all of its students. The product differs by location (students tend to attend colleges relatively close to home), extent of services (prestige, good sports teams, partying, contacts), quality, and image (Harvard's image differs from UCLA's).

Question to Think About: As "firms" in a monopolistically competitive industry, are colleges characterized by excess capacity?

Cheating on Collusive Agreements

Collusive agreements are often difficult to establish and maintain, since it is profitable to cheat. Suppose you are head of a corporation that has made a collusive agreement to set the price of your product at $40, which is above marginal cost. A potential customer wants to buy 10,000 units of the product at $34 each, which also is greater than marginal cost. If you accept, your profits will be greater than if you do not get the sale. Further, the customer informs you that another firm that is in on the collusive agreement has offered to sell the product at $36 per unit. You have to decide whether the customer is telling you the truth and whether to cheat on the agreement yourself. Collusion is profitable, but cheating on the agreement can be even more profitable.

Question to Think About: Would you be more willing to cheat if the order were large than if it were small? How would you determine if other firms were cheating on the agreement?

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Topic: The Fourth Merger Wave

Toward the end of this chapter, a section entitled "Mergers and Oligopoly" discusses merger waves in the United States. The first occurred between 1887 and 1904, when horizontal mergers dominated, meaning the joining of firms that produce the same product. The second merger wave (1916-1929) involved vertical mergers, meaning the joining of one firm with another that either supplies its resources or demands its outputs. The third merger wave peaked in 1964 to 1969, and was characterized by conglomerate mergers, meaning the joining of firms in different industries. The fourth merger wave, which began in the late 1970s has involved both horizontal and vertical mergers and acquisitions. In the 1980s about one-third of mergers were the result of hostile takeovers, where one firm buys control of another against the wished of the management. Hostile takeovers dwindled to less than 10% of all mergers during the 1990s. In 1997 a record 157 mergers of $1 billion or more took place; altogether mergers involving U.S. companies that year totaled a record $1 trillion, an amount exceeding the value of 1996 mergers by 50%. In the last three years, about 27,000 companies merged, topping the total that merged during the entire decade of the 1980s. The most recent wave reflects a growing belief among government officials that big is not necessarily bad. Deals that would have been challenged in the 1980s are now approved. The end of the Cold War stabilized world markets and expanded capitalism around the world. Firms are often merging to become more competitive in the global market. The combination of a surging stock market and relatively low interest rates reduced the cost to firms of funding mergers and acquisitions. (Updated 2/2/98)

Topic: OPEC Raises Production Limits

The section in this chapter entitled "Collusions and Cartels" discusses the problems of keeping a cartel functioning. The biggest problem is the temptation of cartel members to cheat on the agreement. The recent history of the Organization of Petroleum Exporting Countries, or OPEC, has underscored problems of cheating. The official production quota is 25.0 million barrels per day, but because of cheating by members such as Venezuela and Nigeria, which are producing all they can, production by cartel members totals an estimated 27.8 million barrels a day. OPEC, the 11-member oil cartel, decided over the weekend to raise official production quotas by 10%, from 25.0 million to 27.5 million barrels per day. The primary beneficiaries of the higher quotas are those countries that have the capacity to increase production—Saudi Arabia, Kuwait, and the United Arab Emirates. The quantity of oil demanded throughout the world averaged 73.8 million barrels per day in 1997 and is expected to grow to 75.6 million barrels a day in 1998. Thus, OPEC supply accounts for about 38% of the world demand, not a huge share. The rest is met by non-OPEC producers such and those operating in the North Sea. OPEC members are Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. The Monday following the OPEC announcement, the price of oil on the world market dropped 50 cents (or about 2%) per barrel. (Updated 12/4/97)

Topic: Little Caesar's Upsizes Pizza

Monopolistic competition is a market structure characterized by a large number of firms selling products that are close, but not perfect, substitutes. Products across firms are different enough that each firm's demand curve slopes downward. The pizza market seems to fit this description, with a few large firms but tens of thousands of Mom-and-Pop operations. One way that monopolistic competitors try to differentiate their products is based on physical differences. Little Caesar's, the third largest pizza chain in the nation, just announced plans to increase the size of its pizzas without raising the price. The chain will expand the diameter of small, medium, and large pizzas by four inches. The industry standard has been a 10-inch diameter for a small pizza, 12-inches for medium, and 14 inches for large. Little Caesar's small will be upsized to 14 inches, so its small will be as big as its large had been. Pizza Hut and Domino's, the top two sellers in the market, plan to emphasize quality in their promotion rather than quantity. (Updated 9/29/97).

Topic: Pricing Internet Access

Firms supplying connections to the Internet could be considered monopolistic competitors because there are numerous suppliers of slightly differentiated products. For example, America Online offers subscibers special services. Late last year, a number of providers began offering connections for a flat monthly rate, as opposed to additional charges for hourly usage above some basic amount (see the
update for 12/20/96). Surprise, surprise! Internet-access providers have found that the quantity demanded increased substantially since the marginal cost of usage is essentially zero. Some subscribers have been remaining on-line while going to lunch or even going to bed. Providers have been dealing with the traffic jams by adding more equipment and by discouraging frivolous use of on-line connections. For example, many providers disconnect if 15 minutes passes without a key stroke. Some providers reduce access of time hogs during peak traffic periods. And some providers prohibit certain high-use activities such as setting up Web services or sending out mass e-mails. Some providers have dropped their flat-rate pricing policy and have returned to charging based on hours of use. (Updated 3/31/97)

Topic: The Marginal Cost of Internet Service

Firms that supply connections to the Internet are numerous, yet some offer enough additional services to distinguish themselves from other providers. For example, America Online offers subscribers special services. When numerous firms provide similar, yet not identical, products, that industry reflects monopolistic competition. Typically, the rate charged for access was a monthly fee plus an hourly rate for usage that exceeded some maximum. Recently, most providers have switched to a standard monthly rate for unlimited use. This fee structure, in effect, reduced the marginal cost of using the Internet to zero beyond the first hour. With the marginal cost reduced to zero, the number of online sessions has increased by one-third and the length of each session has increased by 20%. As expected, dropping the marginal cost to zero increased Internet use sharply, causing traffic jams in December. (Updated 12/20/96)

Topic: OPEC

The world price of a barrel of crude oil ranges from $22 to $23, which exceeds the target price of $21 established by the Organization of Petroleum Exporting Countries (OPEC). Meeting in Vienna, OPEC members agreed on November 28, 1996 to freeze oil production quotas at their current levels for an additional six months. OPEC members hope that this decision to hold the line on production will keep petroleum prices high despite Iraq's likely resumption of exports when the ban on such exports is lifted. OPEC's agreement will keep production ceilings of OPEC producers at 25 million barrels per day until the end of June 1997. Saudi Arabia, OPEC's largest producer, agreed to cap its production at 8 million barrels per pay, 2 million barrels below its capacity of 10 million barrels per day. Iraq has not been allowed to export oil since it invaded Kuwait, starting the Persian Gulf war in 1990. OPEC ministers are concerned that the target price may not hold because of cheating by OPEC members and because the Iraqi exports could bring nearly 1 million barrels per day to the world market. Some observers argue that the current high price of oil is due to market conditions, such as an expected cold winter combined with reduced stocks of oil on hand, rather than to OPEC planning. (Updated 11/29/96)